Scotland and Brexit vote could reshape UK economy

Politics is creating uncertainty and fears of significant disruption could
stop companies investing in Britain

The politicsof the next few months could fundamentally change the UKPhoto: AFP

By Rob Wood

1:03PM BST 21 May 2014

What is the biggest risk to the UK economic recovery? Is it debt, house prices, interest rates, the Eurozone? No, the biggest risk is politics at home. The way in which policy makers in London and Edinburgh handle the upcoming Scottish referendum is the clear and present danger.

That is not to say the other risks are unimportant. But they can be contained. The Bank of England can do something about house prices if it chooses, for instance. The politics could fundamentally reshape the UK and its economy.

The Scottish risk is not the only one. There are plenty of populist and damaging policy proposals emerging from Westminster. Some of the risks are interrelated. Brexit from the EU would be more likely if Scotland leaves the UK first.

Regardless of your position on the merits of EU exit, it would change the economy and cause significant disruption in the short-term. Companies do not like to invest in a country whose market access is uncertain.

I want to focus here on Scotland. The vote is four months away. The polls suggest a “yes” vote for Scottish independence is unlikely, but increasingly less so. The poll readings differ enormously, though the yes campaign has gained substantial ground in most polls, leaving it 10-15 points behind.

The Scottish Yes campaign’s poll gains have stalled in recent weeks, but that may just be a pause if the example of Quebec’s 1995 independence referendum is anything to go by. The polls there narrowed significantly in the three months before the vote.

This week’s European elections could be a catalyst for further gains. A strong anti-EU vote could push more support from relatively pro-EU Scotland to the independence campaign.

Scottish exit from the UK would change any future EU referendum calculus. First, it would take a chunk of EU supporting voters out of the equation. Second, with Labour holding 41 of the 59 Scottish Westminster seats, Scottish independence would make a Conservative government in the remaining UK, and therefore an EU referendum, more likely.

Uncertainty could spread further. The May 2015 parliament could end up a lame duck administration if Scotland votes for independence. Scots could still vote in the May 2015 UK general election because any legal split of the two countries is unlikely before 2016 at the earliest.

In that case, there may need to be another Westminster election after Scottish independence or perhaps a change in government if the May 2015 winner lost its majority once Scottish MPs leave parliament. Either way, it would be tricky. More potential uncertainty then - it is the enemy of growth but runs through all these issues.

There are risks from the Scottish vote either way. David Cameron this week tried to play down the possibility of a no vote resulting in continued speculation about future independence. But Quebec is a useful example.

Independence questions did not stop after the 1980 referendum vote against a split, and there was finally another vote in 1995. Some observers see the uncertainty during that 15-year period as having been a significant drag on the Quebec economy.

But clearly a yes vote has far greater potential for disruption. At a minimum, it would cause serious short-term economic problems north of the border. General uncertainty, the potential need for a new currency and significant austerity to establish trust in Scottish bonds that would need to be issued after independence would hurt. It is hard to sensibly estimate the quantitative effect. But safe to say it would be serious.

The rest of the UK would not be immune. The economics of separation will be messy for a few years even if the authorities agree on a quick and smooth divorce. If they loudly quarrel about the terms of divorce for long, the impact could be serious as markets and investors abhor uncertainty. For both sides, the short-term cost of divorce would depend largely on their ability to settle their differences fast after the vote, whatever they may have said in the run-up to the vote.

In the long-term, it is the incentives that matter. Scotland is large enough to prosper on its own if it gets its policies right. Other countries do. The question is would political leaders use their powers wisely or not?

The new Scottish government would in all likelihood face fiscal problems. It would have strong incentives to pursue a pro-growth agenda. The benefits of policies would accrue fully to Scotland, and the costs of bad policies would have to be borne by Scotland alone.

On the other hand, the government could lurch to the left with growth sapping policies. History suggests both are real possibilities.

For the UK, losing North Sea oil would hurt an already precarious balance of payments position. But it could also mean sterling depreciates in the long-run. That could help rebalance the economy, eventually.

Where does that leave us then? The No’s poll lead suggests a Scotland is unlikely to vote for independence. Still, these risks are worth watching carefully because they could fundamentally change the shape of the UK over the next few years. But long-term, it is the incentives that matter. The key is that policy makers handle any challenges sensibly.

Rob Wood is UK economist at Berenberg Bank and former economist at the Bank of England